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Many small and medium-sized businesses often rely on a few select employees who directly contribute to the success of the entire company. Unfortunately, this puts the viability of the business at risk if something unexpected happens to one of those individuals. That’s where key employee insurance comes in.
Key person life insurance provides a death benefit to the business in the event of the covered employee’s unexpected passing. It can act as part of a comprehensive business continuity plan to help the business manage the financial impact of losing a key employee by providing the necessary funds to help replace the loss of revenue brought in by the key employee as well as a resource to assist in the finding and training of a replacement employee.
Despite its importance key person life insurance, also called key employee insurance, is often overlooked by owners. According to the Insurance Information Institute, 71 percent of surveyed small businesses reported the company's dependence on one to two people, but only 22 percent of them had a key person life insurance policy in place.1
“Business owners should be looking to make themselves as redundant in the business as possible so as not to make the business too dependent on the owner,” said Brian Trzcinski, a specialist in business market development for MassMutual. “Protecting the business from the loss of a key employee can go a long way towards ensuring that business has the right talent in place to continue its success.”
How can you ensure that your business and those relying on it, like family or employees, are protected? Start now by learning more about how key person life insurance works and when it makes sense for small and mid-sized companies to purchase a policy.
What is key person life insurance?
Key person life insurance covers the unexpected death of one or more employees who are directly linked to the financial or reputational success of the company. The business pays an ongoing premium to keep the policy in place and receives a death benefit in the event the covered individual dies.
If the key employee passes away, the life insurance death benefit can be used to support the business while efforts are made to find a replacement for the deceased employee. Whether to mitigate the impact of a revenue dip or to use if the company wants to employ a search firm to help with the hiring process, the money eases up cash flow and can help reduce financial stress during this often-challenging time.
Depending on the terms, if the policy is not used during the key employee’s working years, it may be possible to convert it to provide an employee benefit when they leave. The employee would take over ownership of the policy and be responsible for any remaining premium payments. The employee’s heirs would then be eligible to receive the policy death benefit and the cash value in the policy could potentially be used as part of a retirement supplement strategy.
A separate disability income policy can help protect the business if a key employee becomes too ill or injured to work rather than passing away.
How to identify key employees
The best way to determine who your key employees are is to ask yourself the following question: If you were to leave your business and start up a new one, who would you take with you? More specifically, there are several situations in which someone might be considered a key employee, such as:
- An individual who directly contributes to a large percentage of the business's income, whether through knowledge, relationships, or specialized expertise.
- A top-performing salesperson who brings in a significant percentage of the company’s revenue.
- A sole proprietor who wants to pass on the business to family members without any financial stress during the transition process.
In addition, you as the owner could be considered a key employee, particularly if you have a specific skill set or function as part of a larger ownership team.
Calculating how much coverage to purchase
The “right” amount of coverage depends on the individual's role and their contribution to company revenue, whether through sales, relationships, or simply the ideas that keep bringing in customers.
For someone who is directly tied to revenue, for instance, it may be easy to calculate a percentage of that cash flow for the period of time it would take to recover from losing them.
Another strategy is to consider the cost to replace a high-level employee, such as hiring an executive search firm, paying a new salary, and including additional benefits to incentivize the best new hire. Finally, a very simplistic way to calculate the amount of coverage you may need is to take a multiple of the key employee’s salary. (Related: Strong teams build strong businesses: Here’s who can help)
Because key person life insurance proceeds may also be used for one partner to buy out the other (or their heirs) in a small-business partnership, the coverage could be based on the business value and the partner’s ownership stake.
This may change over time as the business grows (or declines), so it’s worth reassessing the company’s valuation and the policy amount over time.
Conclusion
Key person life insurance is a resource that may be a crucial part of a company’s overall business continuity plan. The policy can help you protect your business’s most valuable asset — the employees that truly make it successful.
Talk to a financial professional at MassMutual to see if key person life insurance is right for your business. We’ll help you navigate how to define a key person and what amount of policy coverage can help protect your business in an emergency situation.
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Frequently Asked Questions about key person life insurance
Q. What is key person life insurance?
A. Key person life insurance is a policy a business owns on a key employee, paying the business a death benefit if that employee dies. The funds can help cover lost revenue and the cost of finding a replacement.
Q. Who counts as a key employee?
A. A key employee is someone whose loss would cause substantial financial harm to the business — such as a top salesperson, a founder, or someone with specialized expertise or key relationships. A simple test: if you started a new business, who would you take with you?
Q. How much key person life insurance should a business buy?
A. Coverage is commonly based on the employee's share of revenue, the cost to replace them, or a multiple of their salary. The right amount depends on their role and how long it would take the business to recover.
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This article was originally published in August 2019. It has been updated.
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